An early warning sign?

Commentary: Here's why investors should tread carefully in March

By

MichaelK. Farr

KeithB. Davis

WASHINGTON (MarketWatch) -- We can't say we were surprised by the action on Wall Street at the end of February.

Until Tuesday's sell-off, the S&P 500 Index was up nearly 19% from the 2006 low of 1,223 recorded in June of last year. The climb had been unrelenting as investors reacted to evidence suggesting the Federal Reserve had been able to engineer a soft landing for a growing U.S. economy.

While much of the economic data released over the past six months has indeed been positive, we're increasingly worried that investors are ignoring the potential downside risks to the economy. Among these risks are a shaky housing market, tightening lending standards, continued high energy costs, a negative savings rate, and the sheer amount of consumer debt. All these risks could potentially affect consumer spending, which accounts for more than two-thirds of GDP and has been the fuel behind economic growth over the past decade.

For years, consumers have thrown caution to the wind as the skyrocketing value of their homes has empowered them to spend most or all of their income (while still "saving" for retirement).

However, home prices are no longer increasing due largely to affordability and a string of 17 rate increases by the Fed. The negative side effects of a changing housing landscape are many: 1) homeowners feel less rich and therefore are inclined to spend less (wealth effect); 2) lower cash-out refinancings lead to less lavish spending on things such as home improvement; 3) upward adjustments in mortgage rates lead to higher mortgage payments and less money to be spent elsewhere; and 4) increased delinquencies and foreclosures cause banks and finance companies to tighten up lending standards, which leads to less liquidity and ultimately lower consumer spending.

We have yet to see the effects of the changing housing environment on consumer spending, but it's coming.

Another concern about consumer spending is the fact that consumers are spending more than they make. According to the Bureau of Economic Analysis, personal savings as a percentage of disposable personal income turned negative in 2005 and 2006. Many pundits will tell you that this statistic is no longer valid as it doesn't incorporate savings accumulated in the form of home equity or 401(k) plans.

However, if houses are no longer appreciating in value, shouldn't the consumer return to a position of net saving? Furthermore, stock market volatility suggests that consumers shouldn't rely solely on consistent capital gains to fund their retirements. Consumers must begin to save again, which will obviously pressure consumer spending, the pace of economic expansion, corporate profits, and ultimately the stock market.

There are also other exogenous risks that must be considered before allocating new money to stocks at these levels. While energy prices are off their highs, it shouldn't be hard to imagine a situation whereby new highs are reached in 2007. Geopolitical risks abound in the deteriorating situation in Iraq and heightening tensions with Iran. A terrorist event could disrupt the oil supply. Or a bad hurricane season could produce another Katrina in the Gulf of Mexico. Given energy's importance to global economic growth, we must assign some probability of one or more of these events unfolding.

It may seem otherwise, but we're not counting on a doomsday scenario. We're bullish on the long-term outlook for the U.S. stock market. According to Ibbotson's data, stocks are the only major asset class to yield positive inflation-adjusted returns in every 20-year period from 1926 to 2005. We expect this performance to continue.

We live in a free, capitalistic society where innovation and new technologies are rewarded, productivity is increasing, trade barriers are breaking down, inflation is under control, and the government is stable. All of these factors should help companies increase their earnings, and increasing earnings are the best predictor of stock prices over time.

So stay the course if you're in it for the long term, but traders should heed the warning signs on the horizon.

If you're looking to allocate new money to stocks in the near future, our firm would recommend large-cap, flight-to-safety companies with strong earnings visibility. Companies such as General Electric
GE, +1.35%
Johnson & Johnson
JNJ, +1.46%
Citigroup
C, -0.34%
and Pepsico
PEP, +0.08%
appear better equipped to navigate the choppy waters ahead. Now is not the time to get aggressive in untried business models and inexperienced management teams.

Michael K. Farr is president of Farr, Miller & Washington LLC, a Washington-based wealth-management firm. Keith Davis of Farr, Miller & Washington previously worked as a treasury analyst for Capital One Financial. Click here for more information.

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